The market action of the last 10 years has clearly shown the weakness of the primary tool used by the investment advisory industry to manage risk-- passive asset allocation or MPT. While it has its place as one method of risk control for an investor's portfolio, it is not the only method!

Expand your Horizons

Many planners and advisors are using passive asset allocation methods because it's the only strategy they have been exposed to. Others do so because their firms have forced them to use it to manage risk.

They use historical statistics to allocate a portfolio among different asset classes or funds representing those asset classes as the primary method. They then reconsider the allocations based on the investor's circumstances and risk tolerance, make small changes, and rebalance the portfolio to the new percentage allocations. Yet, most of the changes are random in nature and are a reaction to the clients concerns or the advisors fears.

The primary function of the changes is to calm the client and for the advisor to demonstrate that they have done something about their concerns by “window dressing.” This is so they can go back to running their businesses and little to do with the original plan or market conditions.

I believe that financial advisers owe it to their clients to understand alternative methods of risk reduction. They should broaden their horizons and also consider dynamic market timing, dynamic asset allocation, and strategic diversification.

Passive asset allocation or Modern Portfolio Theory (MPT) is risk management based on combining non-correlated asset classes to create a portfolio with risk lower than the average risk of its component parts.

Because it's passive, it cannot respond to evolving market conditions. By definition, it can only deliver mediocre returns (the average return of its component holdings). It takes almost superhuman discipline by requiring proponents to not only hold on to investments that have already taken serious losses, but also to sell portions of the top performers in order to buy more of the losing investments.

Furthermore, it subscribes to the almost un-American ethic that if you work less at your investing, you'll do better.

Fear of the Unknown

The real issue is that most advisors operate in the markets from fear and not from structure or knowledge. So many of the decisions to change a portfolio are reactions to clients concerns or fear of the uncertainly of the market.

Over the last 10 years, financial professionals using passive asset allocation in real life have become somewhat disillusioned. Returns seriously lagged during the bull market. Then adding insult to injury, losses were deeper than expected during the market decline of 2007 to 2009. Previously non-correlated asset classes were suddenly moving in the same direction as prices collapsed.

The financial press responded with front-page stories speculating loudly about the "asset allocation hoax." But there was no hoax, only a failure to understand that there is no Holy Grail approach to investing.

There are other options such as market timing and technical analysis, despite being some the most criticized, they both are valid alternatives.

Many mutual funds and variable annuities, consistent with their obvious conflict of interest on the subject, denounce it. They say you can't time the market. They go through all types of examples so you will buy their funds so they can collect 1 to 2 percent in imbedded fees.

A Change in the Wind

Yet, both market timing and technical analysis seem to be winning over converts by the droves. In a recent comprehensive study of the advisory industry, Financial Research Corp. of Boston found that active management was the fastest growing segment of the financial adviser industry.

The conventional wisdom on the Street is that "studies show market timing doesn't work." Yet in the 1990s, academia produced a stream of papers demonstrating tradable inefficiencies in the market. In addition, the first American Nobel laureate economist, Paul Samuelson, reversed his random-walk-based negativism to market timing, allowing that it might succeed for investors with limited time horizons.

Recently, major studies of the results of large groups of market-timing firms over various time periods have demonstrated that market timers deliver real risk-adjusted returns after fees. In the case of VPM, we have seen 10 years of positive alpha delivered on our equity portfolios and our mutual fund portfolios.

All this is not meant to imply that market timing or technical analysis is perfect Market timing, too, has its considerations. All market timing approaches go through phases of under-performance and over-performance with the market. Some for relatively short periods, some for long periods, and some never return to profitability.

In addition, the translation of the buy decision into action has plagued many timers, as the chosen instrument may not mirror the market being modeled. In volatile or trendless markets, market timing is vulnerable to whipsaws. Studies show that market timing works best the more actively securities are traded. This, plus the 100% in, 100% out trading, can lead to strained relations with fund companies.

Fund company concerns may not be valid, however. They fail to consider netting of opposing trades, cash positions of funds, asset levels, today's lower commission costs, the fact that the addition of days necessary to avoid redemption fees do not address the supposed costs of the eventual trade to other shareholders, and finally, that the fund family industry was built on the back of the very exchange feature that the fund companies now seek to limit.

Still, there is little argument that it can be a daunting task to find sufficient shelf space to trade market timing strategies. Fortunately, the development of the actively tradable fund families such as Rydex, ProFunds, Potomac, as well as exchange-traded funds (ETF) and basket trading have lessened this issue for active managers. I have found that equity based portfolios have the greatest risk control and add more alpha than you can with mutual funds or ETF's.

The Blend of Concepts

Early in the 1990s, a few investment firms began to offer a new risk management strategy--dynamic asset allocation. It mixed much of what is best in passive asset allocation and market timing strategies. The approach is simple: A universe of funds composed of all of the domestic style boxes, international funds, bond funds, and money market funds is assembled.

Based on academic studies that identify one of the best tradable market inefficiencies as the tendency for a rising trend to continue, the funds from the diverse universe are ranked daily, weekly, or monthly, and the best performers are chosen. These funds are held until something else supplants them for the top leadership. Since money market funds are also ranked, they can cushion the blow of a declining market.

This uncomplicated strategy accomplishes a lot. Like passive allocation, it draws on a universe of asset class funds and is diversified into a number of fund positions. But dynamic asset allocation is actively managed and can respond to market conditions. Its focus on the best performing funds helps to prevent it from falling prey to the shortcomings of the passive strategy. It doesn't have to by definition achieve mediocre returns, and it doesn't take money from profitable positions to fund losing ones.

At the same time, dynamic asset allocation avoids the principal downfall of market timing systems; It does not interpose a set of market-related trading rules between the investor and the returns he or she hopes to achieve from a specific investment. Each fund's return/price movement--and only that return--drives the investment, retention, and sell decision. Macro factors cannot get in the way. While it requires much more effort than passive asset allocation, dynamic asset allocation tends to have better risk-adjusted returns.

Implementing a Dynamic Asset Allocation Strategy

This strategy does have some considerations, though. Many of the problematic fund relations issues remain. Also, momentum investing tends to go through trendless, whipsaw periods where small, short-term losses can occur. The practitioner must remember that the strategy simply puts the odds of success on the investor's side. It does not guarantee profits on every trade.

Another technique, strategic diversification, works by combining strategies into a portfolio of strategies. It works much the same way as traditional asset allocation does. Diversifying client investments not only along asset class lines, but also based on the strategic techniques used, further reduces risk. For example, a financial planner can maintain a passive portfolio together with a timed or tactically managed investment and a dynamically allocated investment service.

As with traditional asset allocation, it is important that clients really diversify. In other words, advisers can't combine five similar strategies and expect to reduce risk significantly. That would be like fielding a football team with eleven quarterbacks playing all of the positions. They could be the eleven finest quarterbacks, but as a team trying to fill all the roles, they probably would not be too successful.

Diversification is more than simply owning many different styles and asset classes; they must be different, non-correlated assets. Advisers need to find approaches that work with different asset classes--U.S. equities and their subcategory styles, global investments, bonds, and alternative or defensive investments like precious metals and real estate. They should not shy away from asset classes or strategies that have underperformed in the short run if they have a good long-term record.

To avoid the problems associated with passive asset allocation, active strategies must account for a substantial portion of the strategic portfolio. Active management's value results from the inherent advantage of active over passive strategies--the ability to capitalize on intermediate-term trading opportunities to avoid risk and seek profits. By diversifying among these actively managed strategies, investors will have already captured passive asset allocations singular benefit--lower risk through diversification.

In addition, combining different styles of active management is important. A strategically diversified portfolio should include some tactical (market timing) strategies, as well as the dynamic asset allocation approaches. Different techniques (fundamental, technical, top-down, bottom-up, cyclical, predictive, seasonal, neural net) further the diversification cause. Keep in mind that diversification works to reduce risk only if it is among non-correlated strategies. There is some downside to diversification as over diversification can dilute potential profits or alpha in the portfolio.

Fortunately, advisers are now offering multiple strategies on one investment platform. Non-manager planners can find these offerings on retail platforms in the separate accounts arena for large stock accounts managed by traditional fund providers; they are also available from active advisers utilizing mutual funds and variable annuities. The investment management fees charged to the client, a percentage of assets under management, are split with the referring advisor.

While this is a solution for obtaining diversification for your clients it also is a very expensive option. Most of the out-sourced management cost between 50 and 125 basis points. This represents tens of thousands of dollars in lost revenues for the referring advisor.

The mutual fund and variable annuity product environment is especially appealing. In a stock portfolio, active trading can generate high transaction costs, but active managers working with no-load funds or variable annuity subaccounts have few or no transaction costs (although these costs do exist within the funds or the subaccounts).

On the other hand, separate account managers can better handle the tax costs of their efforts within taxable accounts. Active managers prefer to work in the deferred tax environment provided by IRAs, retirement plans, and variable life and annuity products. Finally, to achieve adequate diversification, investors need to own a number of strategies, so a low minimum account size per strategy may also be an important consideration.

Although they face an increasingly challenging market, investors and their financial advisers have more tools available than before. Employing them all in a single portfolio can achieve a new level of risk reduction. Strategic diversification means today's investor is like a football coach in a close contest. He's not going to use just his defense to win the game. He's going to use every weapon at his disposal--his offensive unit, his defense, his special teams, and all the talents of a well-stocked bench--to bring home a winner.

Waiting for the returns

There have been 14 declines greater than 20 percent since 1929. The big story is in the time it takes to recover from these events. They take much longer than most would think to recover from the declines.

While a passive “Buy and Hold” Approach has worked for many over the years, advisors and clients are learning more every day that they may not have the time needed for the market and their accounts to recover the losses over these time periods. This is especially true when the money that has been saved and invested for years begins to be liquidated to pay for their intended purposes, whether it is for retirement, college savings, or other activities. Once clients’ investments begin to be withdrawn, they may never reach past market peaks again.